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SECURED CLAIMS IN BANKRUPTCY: The Financing of Good and Bad Projects 4

Even so, there are some general reasons to think that partial priority is not as likely to prevent the financing of value-increasing projects as it is likely to prevent the financing of value-decreasing projects. When an efficient activity would otherwise not take place under partial priority because it would confer too great a benefit on nonadjusting creditors, those creditors may find it in their interest to modify their contractual rights to reduce the size of the positive externality, and permit the activity to take place. That is, when nonadjusting creditors would gain from certain activities that will not be financed under partial priority because the equityholders would capture too little of the activities’ benefit, the nonadjusting creditors might agree to reduce their claims (by, for example, forgiving part of their loans) in order to induce the equityholders to undertake the project. The nonadjusting creditors will be better off receiving full payment on their reduced claims than receiving little or no payment on their full claims. Indeed, lenders in workouts commonly agree to reduce the size of their claims, presumably in order to increase the likelihood of eventually receiving payment on the remainder of their claims.

C. The Effect of Partial Priority on the Financing of Post-Bankruptcy Projects
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A partial rule will affect not only the financing of projects outside of bankruptcy, but also the financing of projects in Chapter 11. Dean Baird has suggested two ways in The first is that partial priority would simply provide more money for lawyers to spend on reorganization and would therefore waste resources that would otherwise be allocated to more productive uses. To begin, it is not clear that providing more resources for funding reorganizations would be undesirable. It is possible, as Dean Baird recognizes, that there are currently insufficient assets to finance the reorganization of businesses that should continue to operate. However, assuming, arguendo, that a partial priority rule would, if inserted into the current bankruptcy system, lead to wasteful attempts at reorganization, one could simply modify bankruptcy rules to ensure that the value transferred from secured creditors is not used to pay administrative expenses. For example, value could be transferred from secured to unsecured creditors (according to the fixed-fraction or any other partial priority rule) only at the very end of the proceeding.
The second point Dean Baird makes is that partial priority may make it more difficult to create the financial structure of the emerging company because some parties will prefer full priority. However, this argument is the bankruptcy analogue to the argument discussed above, that full priority is necessary to obtain desirable financing outside of bankruptcy.If partial priority yields a better mix of projects outside of bankruptcy, then it should also yield a better mix of projects in companies emerging from bankruptcy. Of course, if Dean Baird is right that full priority is necessary to achieve the optimal mix of projects in firms coming out of bankruptcy, then this should be true outside of bankruptcy as well.

This post was written by , posted on March 23, 2015 Monday at 4:47 pm